New Internal Revenue Service accounting rules aim to reconfigure the way investors report gains and losses when they sell stocks and mutual funds by putting the burden on those who handle the transactions.

While the rules won't affect equities until 2011 and mutual funds until 2012, the changes to IRS Form 1099-B represent an entirely new method of managing accounts and are intended to curtail what is thought to be widespread tax avoidance.

The IRS is concerned that the existing cost-basis accounting rules allow investors to dodge hundreds of millions of dollars in taxes a year. With help from Congress and President Obama, the agency has revised the rules to require investors to report their realized gains and losses, but switching to the new system will be difficult and expensive for those new to the process.

Brokerage firms and mutual funds that act as brokerage firms to shareholders will be hit the hardest by this new reporting burden, said Stevie Conlon, tax director for GainsKeeper, a division of Wolters Kluwer Financial Services.

Integrating and developing new tools to compute cost basis will be costly and time consuming, Conlon said. For those firms that decide to outsource this task rather than overhaul their entire accounting departments, there are several well-known vendors who already specialize in this area.

"Mutual funds are already a little bit ahead of the curve because they do provide cost-basis information," said Lori-Ann Trezza, vice president of asset services for the Depository Trust & Clearing Corp. "Most brokers haven't been providing this information, except to their high-net-worth clients."

The new rules do not apply to investors in tax-deferred 401(k) retirement accounts.

Widespread Problem

A recent tax study done on behalf of the IRS discovered widespread underreporting of capital gains.

"Congress is very concerned about underreporting," Conlon said. "Cost-basis information wasn't being reported, either because people were making mistakes or because they were trying to get away with something."

It's easy to see why so many investors are confused. Calculating gains and losses is extremely difficult if you don't know the original purchase price, such as with a gift or inheritance.

Plus, a lot of long-term investors choose to reinvest their dividends, which makes it even more difficult to determine actual gains and losses. Under the new rules, investors who choose to reinvest their dividends must record the purchase price every time they reinvest.

Short-term investors often "wash" in and out of a lot of different stocks or funds and don't always keep track of everything. Some mutual funds invest in real estate investment trusts that provide capital returns.

Calculating the correct tax basis is further complicated when you take into account that short-term gains are calculated differently from long-term gains, depending on your adjusted gross income and tax bracket.

Congress decided to close these apparent tax gaps by taking the burden of computing the tax basis away from the average investor and placing it on the broker, Conlon said.

"Anytime you do a liquidation, you have to report the gross," said Rob Enz, senior vice president and general manager of Securities Processing Solutions for Broadridge. "The entity that initiates the liquidation is responsible for filing the 1099-B."

If a customer has a direct account, the mutual fund provides the 1099-B, he said. If they go through a third-party brokerage firm, the firm must provide the 1099-B.

"The new legislation is not intended to substantially change the existing law," Enz said. "The IRS believes people do not accurately report gains and losses. The intent is to make the industry be more accurate and verifiable by the IRS."

Under the new rules, customers will need to declare their methodology when they open a new account, he said, rather than when they submit their taxes. Customers can choose from the first-in, first-out methodology, which assumes they will sell their oldest shares first; an average-cost methodology, which calculates the average cost of all their shares; or they can choose to specify which individual shares they want to sell.

"We need to start asking our customers, 'How do you want to do this?'" Trezza said.

The IRS expects the new rules to generate billions of dollars in lost tax revenue over the next several years, as well as steep fines for non-compliance, but first there are some issues to sort out.

During the rule's public comment period, dozens of companies and industry groups filed questions, concerns and suggestions. The IRS was not available for comment for this story.

The industry is awaiting additional guidance from the IRS and Treasury Department, but many expect that guidance to come late and in waves.

"I'm optimistic we will receive some guidance before the end of the year," Conlon said, "but it's not in the IRS's power to grant an extension. It might be possible to waive penalties for non-compliance at first, but Congress has sized and scored this bill as a revenue raiser. It's easier to pass a law closing a loophole than to raise taxes."


With the deadline for mutual funds still more than two and a half years away, many firms may be tempted to keep these new changes on the back burner in order to focus on more immediate needs, but accounting experts warn the new requirements have a long adoption timeline for a reason: The new rules touch every part of a firm's operations and are anticipated to take firms one to two years to implement.

The average cost of implementing these changes is impossible to predict because of all the variables, Enz said. Companies can take this opportunity to vastly improve their value-added customer service or simply outsource to a specialist.

"People are waiting for the Treasury to release their final recommendations, but you can't wait for them before you start," Trezza said. "It will take at least a year to build and integrate these systems, and they need to be up and running at least a few months before the new rules take effect."

There is always the possibility that some last-minute changes could rattle the best-laid plans, so Trezza recommends adopting a flexible strategy.

"You can't wait for the Treasury to start preparing," she said. "The longer you wait, the more expensive it becomes. You're late if you haven't started thinking about it yet."

(c) 2009 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

Subscribe Now

Access to premium content including in-depth coverage of mutual funds, hedge funds, 401(K)s, 529 plans, and more.

3-Week Free Trial

Insight and analysis into the management, marketing, operations and technology of the asset management industry.